Chapter Three – Key Concepts and Questions (KCQs)

Key Concepts

There are four general purpose financial statements: balance sheets, income statements, statements in changes of equity and cash flow statements. I never knew there was more to a company’s financials than the straight up income and end profit they have.

The balance sheet is the one statement that shows a snapshot of the business on a particular day at a particular time. It details the company’s assets, liabilities and equity on a possible two sheets – the consolidated balance sheet which includes the company’s subsidiary financials and the standard balance sheet which is just the parent company on its own.

The income statement, on the other hand, shows how the company has changed over time since the previous report. It shows the company’s revenue and expenses. To me, this seems like the most loved and common statement in company’s reports. All people, well… I, tend to care about is the bottom line, whether the company is making money or losing it and this statement shows me exactly where all the good stuff is coming from and then where they’re throwing it away. A nice healthy stream of revenue is just what anyone would like to see (especially in my own bank account, please).

The statement in changes in equity is the third financial statement. It details the change in the shareholders’ equity over the period. I personally don’t have much interest in this statement as I am not an investor and it’s not my equity being tossed around the place, so the only people who would really have a vested personal interest would be those that had a financial stake.

The fourth financial statement is the cash flow statement which shows the opening and closing cash balances for the period and the cash inflows and outflows for the period. I had always wondered (since I commenced my accounting course two weeks ago) what the importance of the cash flow statement was and the study guide finally enlightened me. The biggest breaker of a business is going bankrupt (going into liquidation) and that’s the result of running out of cash, the most important asset. At the end of the day, that’s the measure of a business’ value and if it runs out, it means the business is unsuccessful. The cash flow statement, as I now realise, helps keep track of the inflows and outflows of cash so as to monitor how the business is maintaining and enhancing its most valuable asset.

It’s not just good enough to have these financial statements just sitting there doing nothing except looking pretty confusing, you have to be able to make sense of them. One way is ratios, which analyses the relationships between different items in the financial statements. It’s just like baking a cake, where when you increase or decrease the amount of mixture you need or how many cakes you have to make, the numbers/amounts of the ingredients/items change in proportion with each other. You don’t double the number of eggs without doubling the sugar as well. It’s all about proportion and structure, you need a certain combination of ingredients, a framework of what you need, in order to successfully make the cake.

All in all, every business works on the same basic ideologies and values, trying their best to make their business profitable and successful. Through financial statements, users – be it individuals, shareholders, businesses, creditors and anyone else so inclined – can look and understand the basics of a company and what makes it tick. The annual report and its financial statements illustrate the essence of what has occurred during the time elapsed since the previous report and allows for users to interpret meaning and understanding from the information presented.

Things I Find Confusing

What I find confusing is how a company’s financials can be separated into ‘Parent’ and ‘Group’ categories. Isn’t a company a sum of the whole? Essentially a company IS each of its components, so the group is the parent in my interpretation. If a company is made up by its subsidiaries, how do you separate the subsidiaries from the company as the subsidiaries make up the company?

It states that “An item called non-controlling interests or minority interests in the equity of your firm’s balance sheet represents the equity in the subsidiary companies not owned by the parent company (and thus not owned by the equity investors in the parent company).” So does that mean that if a company does own the entire 100% of a subsidiary company, than the equity investors also in a sense own the subsidiary as well? And if so, why doesn’t the parent company just absorb the subsidiaries into itself and its own operations? It is essentially the same company now as it’s owned by them?

Things I Find Difficult to Understand/Believe

What I find difficult to believe is how in the blazes this phrase “As a guy, I am determined to do my bit to reverse this worrying statistic in the future” ended up in my study guide. Really, really? I feel like I’ve launched from a study guide into someone’s diary.

Back on a more serious note, the whole cash flow and dividends concept is a little hard to grasp. Having never encountered dividends and the share market beyond that annoying thirty second update on the news, it is a foreign topic to me. Buying shares in itself is a rather confusing process, and dividends aren’t any easier. I understand that dividends are paid to shareholders – equity investors – but how and when and why they distribute them is unclear. Isn’t giving away all of your profits a bad idea in case of misfortune? And then, not rewarding shareholders discourages investment, right?

The study guide includes the formula Dividends (d) = Operating cash flow (C) – Capital outlays (I) + Net cash flow from debt owners (F) and then goes on to change the formula in a way I don’t quite comprehend. It then goes on to say cash flow which makes up the ‘C’ variable can mean completely different things and numbers. Combining all these different aspects that don’t quite click for me, just makes for a super confusing experience.

Things I Find Boring

Sometimes I find the text again goes off on a tangent of flowery, descriptive language that doesn’t really add to the topic, it just makes it more longwinded and on occasion hard to read. It also restates the same phrase again and again, just in different words – exactly how my English teacher always told me not to write! It just makes it seem like there’s more information, but it’s just sugar-coating nothing. It makes the text drag on and on, and make it’s boring to read. Also, the repeated references to texts we’ve never read that don’t even add to the topic at hand add to the longwindedness of the text.

The whole section on ratios was rather monotonous as the text never really got to the point of ratios; the definition of what they actually are, what their purpose is and why they’re specifically relevant to accounting and decision making.

Things I Find Exciting/Surprising

I really like the comparison to introductions at parties. At just a quick introduction, you smile and say hi, but after ten minutes you’re whisked off in the excitement of dancing and music (and alcohol, if you’re so inclined) and you tend to forget all about them. But, if you get to know them better, you remember them and have the beginnings of a relationship.

I remember being invited to my friend Shane’s 12^th birthday party a few years ago (okay, more than a few). He had gone to a different school for about a year and a half and, as expected, had made new friends that I didn’t know. There were two girls, one I talked to all night and one that I didn’t. The girl I talked to was Rebecca and I could tell you a number of things about her. The other, I couldn’t even tell you her hair colour. The point is, after spending a few hours getting to know Rebecca; I knew so much more about her and built a friendship that lasted years that involved me learning things about her I never would have guessed in the beginning. Even now that I haven’t spoken to her in 12 months or so, I still remember all these things.

The same goes for financial statements; if you spend the time getting to know them, you’ll learn more about them slowly but surely, and even if you don’t go near accounting for the next ten years, you’ll still remember the main important things about them (and even some things not so important) and have a ‘relationship’ with them.

To further the analogy of financial statements being like people, they all have similarities and differences, as Martin points out when he says “But just as we each have a different face, so our faces also have some similarities.” Financial statements can also have different names, just like people have different nicknames they respond to; like Emily can be referred to as Em, Emmy, Emse, Emsey, Emsalee, etc. etc. They still refer to the same person just as different names for a specific financial statement still refers to the same thing. And just like people, you can get along with some financial statements better than others, for example; the balance sheet and I are best buddies, love hanging out with that guy, but the statement in changes in equity, he and I are best kept at a hundred paces unless you want a restraining order brought out.

Chapter One – Key Concepts and Questions (KCQs)

Key Concepts

This chapter was a nice and easy immersion into the idea of accounting. It details the history of accounting, why we use accounting

We use accounting in order to understand a business and its realities. Is it successful? Everyone knows, even if they’re not an accountant, that money – value – is what makes the world go round. You always see little kids at the shops grabbing at lollies and toys and at the same time see their parents scolding them that you can’t just take them, you have to pay for them. You very quickly understand at a young age that you can’t get something for nothing and everything has a value. Accounting just shows us how this value is calculated and created.

Another key concept is that of how businesses can be run under different types such as a sole trader (owned by one person), a partnership (owned by two or more people), a company (separate legal entity from owners and comply with the Corporations Act) and a trust (where a trustee carries on the business for the beneficiaries).

The concept of double-entry accounting has been around for centuries and even though technology has advanced, we still maintain that method because that’s the way it’s always been done and if it ain’t broke, don’t fix it. It is the process of maintaining the relationship between each aspect of a transaction. Basically, I see it as the business version of Newton’s Third Law– every action has an equal and opposite reaction.

In order to keep track of all these tricky and confusing transactions in everyday business activities, bookkeepers use two books, journals and ledgers. The journal keeps a chronological list of all the transactions that occur every day and the ledgers categorise these transactions into their relevant accounts.

The balances of the ledgers are then brought to a trial balance where the balances of debits are added and compared to the sum of the credits where they should be equal. It is a trial balance because it helps pick up errors.

Debits and credits are the two sides of a transaction. Debits are owed, and credits are entrusted.

The accounting equation of Assets – Liabilities = Equity. It illustrates the relationship of the interest of the owners. I understand it as assets are like your salary, you have to pay all your bills first and then whatever is left over is what you get to play with and enjoy (or more sensibly, stash away just in case). This equation expands to Assets + Expenses = Equity + Revenue + Liabilities.

Whew, there was a lot of material covered in this chapter, but luckily it was relatively simple and easy to understand. For me, at least.

Things I Find Confusing/Difficult to Understand

The whole concept of debits and credits has been a little difficult for me to get a handle on. I just couldn’t for the life of me figure out which one was which and where they went in a transaction. It was just a big old mess and let me tell you, it really stressed me out. If I can’t understand this basic, fundamental concept, how screwed am I for the rest of the term? It wasn’t until the textbook question about explaining debits and credits to your friend who doesn’t understand using a car driving on a street as an example. I ended up writing:

“Debits are recorded on the left-hand side and credits are recorded on the right. Debits increase assets, expenses and drawings from owners. Credits increase revenue, liabilities and investment by owners. Driving on the left-hand side, assuming you are driving away from your business, this is the flow of money out of the firm. Driving on the right-hand side are the cars heading into your business, this is the flow of money into your business.”

After this, it all of a sudden just clicked. It was like the sun had broken through the clouds and the angels appeared with their trumpets. I had figured it out! Hallelujah for that. I still get them a little messed up sometimes when I think too hard about it, but when I stop trying to overthink it all, I sort it out again.

Things I Find Boring

In reading this chapter, I found the inclusion of the incessant focus on “businesses are everywhere” rather monotonous.

“I am writing this chapter in Yeppoon, a small coastal town in Central Queensland near Rockhampton. I have just had a short walk around the area, and businesses I saw include a dentist, Icon Dental Group, and right next door The Coffee Club, a cafe with a great spot just near the beach. Nearby is Elders Real Estate, Yeppoon Car Wash, and Sullivan Nicolaides Pathology (which provides medical services). There is also David Eaddy & Co (solicitors), Johnson & Tennent (chartered accountants), CEADS (Capricorn Engineering & Drafting Services), Yeppoon Medical Centre, Betta Electrical Yeppoon (electrical retailer), Marsden Tavern (retails alcohol and provides various entertainment services), Young’s Coaches (the local bus company), Sandy’s Cafe, Subway, Rip Curl (clothing & swimwear retailer), Sleepzone (beds and bedding retailer), Woody’s Foodworks Yeppoon (supermarket), Paintplace Yeppoon (paint retailer), Yeppoon Tattoo Studio (tattoo services), Tanby Roses Florist (retails flowers and manufactures flower arrangements), Tai Ho Indian Restaurant, James Street Medical Centre and Centrelink Yeppoon (a government agency providing social welfare payments).

Other businesses I saw were Dollars and Sense (discount variety store), Sail Inn Motel (sells accommodation services), Office National Express (retails office supplies), Happy Sun Chinese Restaurant, S.M. Weston Optometrist (sells eye services and retails spectacles), Yeppoon Health & Fitness Centre (gym services), Pacific Hotel, Wavelengths (hairdresser), Megalomania (bar and bistro), Jaques Coastal Meats (butcher), Video Ezy, St Ursula’s College (a private school that sells education services), Wendy’s (ice cream/cafe), Coles (supermarket), Ian Weigh Toyota (car dealer), Regals Dental (another dentist), Blue Dolphin Caravan Park, Shell (petrol station), Seaside pools (builder of pools), Yeppoon Self Storage, Flexihire (equipment hire and sales), Wot A Sign (sign makers, printer & website designer), Central Queensland Sailmakers (retails, installs and manufactures yacht sails, shade sales, marine upholstery), Yeppoon Veterinary Surgery, Yeppoon Kitchens (manufactures and installs kitchens), Firewood2Furniture (manufactures custom built timber furniture) and Trevor’s Trim & Upholstery (retails, installs and manufactures shade sales, blinds, marine & household upholstery). I took a few photos of these businesses which are included in Figure 1-1 below.”

This whole great big chunk of text is just a waste of time and space. Just look at it. It’s now taken up a whole page of my own text. Big waste of space, isn’t it?

Everyone has walked down thousands of streets in their lives and make purchases from these types of businesses all the time. I know that there are a gazillion different businesses around me and being on the other side of the nation, I don’t particularly care about some businesses in a tiny town on the east coast. Then going on to fill two whole pages with images of these business names is a little on the heavy handed side, particularly when it’s not particularly relevant.

Things I Find Exciting/Surprising

The concept of businesses being organised in different types really intrigued me. I knew that there had to be some sort of difference between your little corner store and your major international corporations. I never really thought much about how little businesses around me could vary in themselves.

When I did my tax return two weeks ago, I looked at the bottom of my dad’s group certificate and saw that the business he works for is organised as a trust. Ordinarily, I wouldn’t have any idea what that meant and how it worked. I knew that the business was run by a husband and wife team, but had absolutely no idea how that translated into a business structure. Now I have a better understanding of how their hierarchy and business management functions which now helps me understand when dad comes home and talks about what’s happened during his day.